Community surplus and the externality diagrams

Overview

Consumer surplus.

What you need to know

Answer each one before you reveal it.

Questions from this subtopic

Each one with the model answer underneath.

1. 1

   Define consumer surplus, producer surplus and community surplus.

   Model answer

   Consumer surplus is the difference between the maximum price consumers would have paid for each unit, shown by the height of the demand curve, and the price they actually pay; on a diagram it is the area below the demand curve and above the price line. Producer surplus is the difference between the price received and the minimum price at which producers would have supplied each unit, shown by the area above the supply curve and below the price line. Community surplus is the sum of the two.

2. 2

   In a market with no externalities, at which quantity is community surplus maximised, and why?

   Model answer

   At the free market equilibrium quantity. Up to that point the demand curve lies above the supply curve, so every unit adds something to the combined surplus. Beyond it the supply curve lies above the demand curve, so extra units would subtract from the total. Since demand measures marginal social benefit and supply measures marginal social cost when there are no spillovers, the equilibrium satisfies the allocative efficiency condition and community surplus reaches its maximum there.

3. 3

   Draw and describe in words the diagram for a negative production externality caused by a factory discharging waste into a river.

   Model answer

   Put price, cost and benefit in £ on the vertical axis and quantity per period on the horizontal. Marginal private cost slopes upward and marginal social cost is drawn above it, the vertical gap being the marginal external cost. Marginal private benefit and marginal social benefit coincide, so there is a single downward-sloping demand curve. The market produces at Q1, where marginal private benefit meets marginal private cost. The social optimum Q* is where marginal social benefit meets marginal social cost and lies to the left of Q1, so the market over-produces by Q1 minus Q*.

4. 4

   In a negative production externality diagram, where does the welfare loss triangle lie and what does it represent?

   Model answer

   It lies between the marginal social cost curve and the demand curve, over the range from the socially optimum quantity up to the market quantity, with its apex at the optimum where those two curves cross. Over those units marginal social cost exceeds marginal social benefit, so each one adds more to the costs borne by society than to the benefits enjoyed. The triangle measures the total amount by which those extra costs exceed the benefits gained, which is the community surplus destroyed by over-producing.

5. 5

   A factory's production imposes an external cost of £3 per unit. The market produces 1,000 units per period and the socially optimal output is 700 units. Calculate the welfare loss.

   Model answer

   The base of the welfare loss triangle is the over-production: 1,000 minus 700, which is 300 units. Its height at the market quantity is the marginal external cost of £3 per unit, since that is the vertical gap between marginal social cost and the demand curve there. Welfare loss = one half × base × height = 0.5 × 300 × £3 = £450. The market therefore destroys £450 of community surplus per period by producing beyond the optimum.

6. 6

   Draw and describe the diagram for a negative consumption externality such as cigarette smoking.

   Model answer

   The vertical axis shows price, cost and benefit in £ and the horizontal axis shows quantity per period. Marginal private cost and marginal social cost coincide, so a single upward-sloping supply curve is drawn. Marginal private benefit slopes downward and marginal social benefit is drawn below it, the vertical gap being the marginal external cost of consumption. The market consumes at Q1, where marginal private benefit meets the supply curve. The optimum Q*, where marginal social benefit meets marginal social cost, lies to the left of Q1, so there is over-consumption of Q1 minus Q*.

Other ways to work this

The same content, four other ways.

What is inside Levo

Six ways to work the same material.